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Premium member Presentation Transcript Theory of consumer behavior on the basis of Measurement of Utility: Theory of consumer behavior on the basis of Measurement of Utility Cardinal Utility Theory of Consumer Behavior And Ordinal Utility Theory of Consumer Behavior Seeks to explain the decision making behaviour of the consumer in demanding a Particular commodity. Economists have offered theories on the basis of the measurement of utility.Marshallian Cardinal Approach or Marginal Utility Approach or Marshallian Theory of Demand: Marshallian Cardinal Approach or Marginal Utility Approach or Marshallian Theory of Demand Concept of Utility and its Cardinal Law of Diminishing Marginal Utility 3. Law of Equi Marginal Utility (Income and Substitution Effect)UTILITY ANALYSIS OF DEMAND-MARSHALL: Behaviour of a rational consumer with demand curve (Law of Demand). D curve is downward sloping towards right indicates consumer tends to buy more when P falls. -ve slope = inverse relationship between P and D. UTILITY ANALYSIS OF DEMAND-MARSHALL D P1 P2 Q1 Q2 D Price Qt. DemandBasic Assumptions of MUA: Basic Assumptions of MUA Cardinal utility-U is measurable. Independent Utility. Additive U Constant MU of Money Diminishing Mu Rationality Introspective AnalysisLaw of Diminishing Marginal Utility and The Law of Demand: Law of Diminishing Marginal Utility and The Law of Demand Utility is the level of satisfaction from the product bought by the cust. Utility is the satisfaction of consumer from consumption which can be measurable ( i.e. be quantified ) and discernible ( i.e. comparable ). Marginal Utility (MU) is +nal U from +nal unit purchased. L of D based on LMU. From the observation of real life situation, the theory suggests that , the total utility of a consumer will increase through consumption, but for successive units of the goods consumed, the additional or extra units of utility got - the marginal utility will gradually diminish According to the law, the consumer tries to equalize MU of a commodity with its price so that his satisfaction is maximized and he will reach equilibrium point. MUx=Px When P falls, MU > than P-----No equilibrium , no max of TU. Hence he’ll decrease MU till = reduced Price. Increase in stock MU decreases. Consumer buys more when P falls.Marginal Utility of Chocolates and Ice Cream: Marginal Utility of Chocolates and Ice Cream Total Income limited to Rs. 60 per week. Chocolate and Ice cream both cost Rs. 10. To buy more chocolates, he has to give up ice cream and vice versa. MU goes of chocolates goes on diminishing as he consumes more and more units. Chocolates per Week (Rs. 10) Ice cream per Week (Rs. 10) MU per Rs on Chocolates MU per Rs on Ice Cream 1 5 10 2 2 4 8 4 3 3 6 6 4 2 4 8 5 1 2 10Assumptions: Assumptions The wants of a consumer remain unchanged. He has a fixed income. The prices of all goods are given and known to a consumer. He is one of the many buyers in the sense that he is powerless to alter the market price. He can spend his income in small amounts. He acts rationally in the sense that he want maximum satisfaction Utility is measured cardinally. This means that utility, or use of a good, can be expressed in terms of units or utils. This utility is not only comparable but also quantifiable.The Law of Equi-Marginal Utility: The Law of Equi-Marginal Utility This law states that the consumer maximizing his total utility will allocate his income among various commodities in such a way that his marginal utility of the last rupee spent on each commodity is equal. The consumer will spend his money income on different goods in such a way that marginal utility of each good is proportional to its price. This law states that how a consumer allocates his money income between various goods so as to obtain maximum satisfaction An extension to the law of DMU . The rationale is that as long as the marginal utility of any two or more goods are different, a consumer will try to consume the good with a higher marginal utility.MARGINAL UTILITY THEORY: MARGINAL UTILITY THEORYSlide 10: Quantity Good A Good B Possibilities T U M U T U M U Q A Q B T U of A & B 0 0 / 0 / 0 7 0 + 110 = 110 1 10 10 24 24 2 6 19 + 104 = 123 2 19 9 45 21 4 5 34 + 94 = 128 3 27 8 64 19 6 4 45 + 80 = 125 4 34 7 80 16 8 3 52 + 64 = 116 5 40 6 94 14 6 45 5 104 010 7 49 4 110 6 8 52 3 114 4 Result : M U of A / Price of A = M U of B / Price of B = 7 units of utility / $ 1 Given : Income = $14 ; Price of A = $1 ; Price of B = $2.Explanation: Explanation Consumer will be at equilibrium when, MUx/Px=MUy/Py i.e when the ratio of marginal utilities and price are equalized in purchasing the various commodities. If P of X falls, then might be MUx/Px > MUy/Py. To attain equilibrium, consumer will reduce MUx and increase MUy till both ratios are equal. Will purchase more units of X and less of Y. Will substitute of X for Y till both MU and Price of X and Y are equal i.e. MUx/Px = MUy/Py. This Price change is expressed by Marshall as Substitution Effect and Income Effect.Concept of Utility and its Cardinal: Concept of Utility and its Cardinal Condition of Consumer Optimum : Utility Maximization From the example above, the consumer will consume a different quantity of good X and Y. The MU ( obtained by the last Rs. spent ) derived from the good X & Y will equal so that a state of equilibrium could be reached. MUx / Px = MUy / Py = MUz / Pz ..... ( A state of consumer optimum ) If the equation is re-written into another form : MUx / MUy = Px / Py ..... ( The ratio of MU of any two goods =Their relative price )Substitution Effect: Substitution Effect When P decreased of a commodity, consumer is induced to substitute more of the relatively cheaper commodity for the dearer one (no change in price). To increase his total satisfaction he purchased of the cheaper commodity. Most common psychological attitude of every consumer. Since SE is always +ve, will buy large Qt. at lower price.Income Effect: Income Effect Refers to changes in real income of the consumer due to changes in price. When P decreases , purchasing power of the real income increases, can purchase more with the same money. IE can be +ve, -ve or Zero. When a commodity has relatively high MU, the IE will be +ve such that the surplus amount realized due to P decrease may be spent on the same commodity. IE= 0 , if entire surplus income is spent on some other comm. IE= -ve, if Qt. purchased is less than before ( inferior good). If both SE and IE are +ve, consumer will increase purchase with fall in price. Even if IE is -ve, SE is relatively so forceful that it outweighs -ve IE, the consumer will demand more at reduced prices. Therefore when Price decreases, D increases and vice versa.Limitations of Law of Equi-Marginal Utility: Limitations of Law of Equi-Marginal Utility It is difficult for the consumer to know the marginal utilities from different commodities because utility cannot be measured. Consumer are ignorant and therefore are not in a position to arrive at an equilibrium. It does not apply to indivisible and inexpensive commodity. Ex: TV sets, Houses, etc. Alfred Marshall accepts the cardinal approach. He further believes that the MU of money is constant. This is a highly controversial assertion but it makes the analysis simpler.Limitations of Marshallian Approach: Limitations of Marshallian Approach Untenable Cardinal measurement of Utility Wrong conception of +ve Utility Homogeneity Assumption is Unrealistic Separate measurement of Utility Constancy of MU of Money Inapplicability in case of Indivisible or bulky goods. Incomplete Analysis of Price Effect Inadequate Explanation of Giffen Goods Limited Scope No empirical Test You do not have the permission to view this presentation. In order to view it, please contact the author of the presentation.